The Bonfire of the Automated Trading Strategies

In a single week in early August 2007, one of Goldman Sachs’s hedge funds lost as much as $1.5 billion, about 30 percent of its value–a stunning loss, but by no means unique in the industry. In the same stretch, billions of dollars melted away from other top funds, too.

It all started with a high number of people defaulting on subprime loans (loans extended to high-risk customers). A few hedge funds, notably the Bear Stearns High-Grade Structured Credit Fund, had bought up these loans and repackaged them as credit derivatives to use as collateral in further transactions. As the derivatives tanked, investors were forced to sell off higher-quality securities–blue-chip equities such as Microsoft, IBM, and General Electric–in order to make up shortfalls in collateral. As the sell-off spread, the downturn accelerated into a nosedive (see “The Blow-Up”).

Afterwards, some critics argued that the computer models used to value financial products had become so complex that buyers didn’t know what they were getting; others held that computer-based trading strate­gies had exacerbated the sell-off. It was not the first time computers had been blamed for financial turmoil.

In a Technology Review article from February/March 1988 titled “Did the Computer Cause the Crash?”, Lester C. Thurow, then dean of MIT’s Sloan School of Management, argued that computer-driven trades were not at fault for the market’s single-day 508-point drop on October 19, 1987, a day now known as Black Monday. Of the ‘87 crash, Thurow wrote,

Computers make program trading possible because they can monitor more information faster and give the appropriate buy or sell orders long before a human could figure out what to do. However, the techniques of program trading and the software used to practice them are very much human creations. Like all expert systems, they merely mimic the actions of a human expert, in this case a broker. The computer can only respond to events that have already happened and act according to the rules built into the program by the broker. Thus, to blame the market’s rapid fall on the fact that computers are automatically executing decisions that brokers would have made anyway is to make the common mistake of blaming the tool for the actions of the people using it.

If the computer did not cause the crash, what did? It depends on what you mean by the question. If by “cause” you mean the immediate cata­lyst of the 508-point decline on October 19th, the answer is that nothing or no one in particular caused it. Rather, it was the product of herd panic, not so different from the sudden panic that occurs among herds of antelope on the plains of Africa. To know why the crash took place precisely when it did would require understanding herd psychology, and even the best animal behavior experts don’t pretend to know why antelopes (or humans) panic precisely when they do.

In the summer of 2007, ^­computer models were still very much human creations. Once fund managers understood what was happening–too many computers were executing the same types of trades based on the same strategy–the models were altered, and in time, many losses were recovered. Still, the underlying cause of the panic is as debatable now as it was for Thurow in 1987:

Since higher interest rates mean constraints on economic growth, it was inevitable that the stock market would fall (whether slowly or quickly) to bring the price of stocks back into equilibrium with that of bonds. Whether stocks were being traded by computers or humans is beside the point.

As to how … markets were able to get so far out of line without an earlier correction, that is a complicated story. Put simply, it depends upon the age-old willingness to suspend one’s critical judgment when lots of money is being made. It happened in the Dutch tulip mania of 1637. It happened again in the computerized stock market of 1987.